The Cost of Capital for Foreign Investments

1
The Cost of Capital for Foreign Investments

• P.V. Viswanath
• International Corporate Finance

2
The cost of capital

• In what follows, we will assume that the
  subsidiary or project cashflows have been
  restated in dollars. Hence the issue is coming
  up with a discount rate that is appropriate for
  dollar flows.
• In principle, the cost of capital used should be
  a forward-looking rate. However, in practice,
  the components of the cost of capital are often
  estimated using historical data.
• While this is unavoidable, historical estimates
  should be used with care.
• An alternative method is to use the Adjusted Net
  Present Value approach, where the project is
  valued as a stand-alone all equity project and
  impact of the the different financing frictions
  are added to this base value.

3
The WACC

• If the financial structure and risk of a project
  is the same as that of the entire firm, then the
  appropriate discount rate is the Weighted Average
  Cost of Capital (WACC)

• where
• ko WACC
• L the firms debt-to-assets ratio (debt ratio)
• id before-tax cost of debt
• ke cost of equity
• t marginal tax rate of the firm
• However, in using the WACC for project selection,
  the L used must be the target debt ratio.

4
The cost of equity

• According to the CAPM, the required rate of
  return on an asset is given as

• Rf risk-free rate
• bi beta of asset i, a measure of its
  non-diversifiable risk.
• In principle, the CAPM applies to all assets, but
  in practice
• It is used to estimate the cost of equity
• It is rarely used to estimate the cost of debt
  because it is very difficult to estimate a beta
  for debt securities.

5
Beta Risk of Foreign Projects

• Foreign projects in non-synchronous economies
  should be less correlated with domestic markets.
• Paradox LDCs have greater political risk but
  offer higher probability of diversification
  benefits.
• Where there are barriers to international
  portfolio diversification, corporate
  international diversification can be beneficial
  to shareholders.
• Studies have shown that international index
  movements explain returns on domestic companies,
  after accounting for the domestic component of US
  indexes. This suggests that there is a
  significant benefit from the ability of
  multinational corporations to invest abroad.

6
Issues in estimating cost of capital for foreign
projects

• In order to estimate a beta for the foreign
  subsidiary, a history of returns is required.
  Often this is not available. Hence, a proxy may
  have to be used, for which such information is
  available.
• Should corporate proxies be local companies or US
  companies?
• The beta is the estimated slope coefficient from
  a regression of the stock returns against a base
  portfolio, which is the global market portfolio,
  according to the CAPM. However, this assumes
  that markets are integrated.
• In practice, is the relevant base portfolio
  against which proxy betas are to be estimated,
  the US market portfolio, the local portfolio, or
  the world market portfolio?
• Should the market risk premium be based on the US
  market or the local market or the world market?
• How should country risk be incorporated in the
  cost of capital?

7
The Correct Approach in Principle

• If we assume that the multinational in question
  is a US multinational with investors who are
  globally diversified, then, in principle, the
  beta of the foreign subsidiary should be
  estimated with respect to a global market
  portfolio, and a global market risk premium
  should be used.
• Furthermore, if cashflows are measured in
  dollars, the right risk-free rate to be used is
  also the US Treasury rate.

8
The Correct Approach in Principle

• However, in practice,
• US investors may not be globally diversified, and
• It may be easier to obtain US data than global
  data
• Consequently, US MNEs often evaluate projects
  from the viewpoint of a US investor, who is not
  diversified internationally.
• Furthermore, a recent study (2004) showed that a
  cost of capital estimated using a domestic CAPM
  model is insignificantly different from a cost of
  capital computed using global risk factors.
• Consequently, the base portfolio used for beta
  estimation is a US index (such as the SP 500).
• Furthermore, since US projects are evaluated
  using a US base portfolio, foreign projects can
  be compared to a US project, if the base
  portfolio is the same US market in both cases.

9
Proxy Companies

• Since we want a proxy as similar as possible to
  the project in question, it makes sense that we
  use a local company.
• The return on an MNCs local operations will
  depend on the evolution of the local economy.
• Using a US proxy is likely to produce an upward
  biased estimate for the beta.
• This can be seen by looking at the definition of
  the foreign market beta with respect to the US
  market
• Foreign companies are likely to have lower
  correlation with the US market than US companies.

10
Proxy Companies

• If foreign proxies in the same industry are not
  available (say because of data issues), then a
  proxy industry in the local market can be used,
  whose beta is expected to be similar to the beta
  of the projects US industry.
• Alternatively, compute the beta for a proxy US
  industry and multiply it by the unlevered beta of
  the foreign country relative to the US. This
  will be valid, if
• The US beta for the industry is the same as that
  of that industry in the foreign market as well,
  and
• The only correlation, with the US market, of a
  foreign company in the projects industry is
  through its correlation with the local market and
  the local markets correlation with the US market.

11
The Relevant Market Risk Premium

• Again, in principle, one would want the global
  risk premium. However, if the base portfolio
  used is a US one, then the market risk premium,
  too, should be based on the US market.
• As before, US markets have much more historical
  data available, and it is a lot easier to
  estimate forward-looking risk premiums for the US
  market.

12
Summary

• Find a proxy firm/portfolio in the country in
  which the project will be located.
• Calculate its beta relative to the US market.
• Multiply this beta by the risk premium for the US
  market to get a project risk premium.
• Add this risk premium to the long-term US nominal
  risk-free rate to obtain a dollar cost of equity
  capital.

13
Country Risk Premiums

• The previous approaches that use US base
  portfolios and/or US proxies effectively ignore
  country risk, assuming that it is diversifiable.
  However, this may not be the case. In fact, with
  globalization, cross-market correlations have
  increased, leading to less diversifiability for
  country risk.
• Furthermore, it may not be enough to look at the
  beta alone of a foreign project's beta, because
  this only deals with contribution to volatility.
• Skewness or catastrophic risk may be significant
  in the case of emerging markets. The impact of a
  project on the negative skewness of the
  equityholder's portfolio could be significant and
  should be taken into account.

14
Country Risk Premiums

• For example, India's beta could be negative, but
  it would not be appropriate to discount Indian
  projects at less than the US risk-free rate.
• If investors do not like negative skewness (i.e.
  the likelihood of catastrophic negative returns),
  we should augment the CAPM with a skewness term.
• An alternative would be to estimate a country
  risk premium based on the riskiness of the
  country relative to a maturity market like the
  US, and to incorporate this into the cost of
  equity of the project.

15
Estimating Country Premiums

• Country Premiums may be estimated by looking at
  the rating assigned to a countrys
  dollar-denominated sovereign debt.
• One can then look at the spread over US
  Treasuries or a long-term eurodollar rate for
  countries with such ratings (sovereign risk
  premium). This spread would be a measure of the
  country risk premium.
• One could also look at the spread for US firms
  debt with comparable ratings.
• Optionally, one might then adjust this spread by
  the ratio of the standard deviation of equity
  returns in that country to the standard deviation
  of bond returns to convert a bond premium to an
  equity premium.

16
Using the Country Premium

• The country risk premium that is obtained can
  then be used in two ways
• One, it could be added to the cost of equity of
  the project. This assumes that the country risk
  premium applies fully to all projects in that
  country
• Two, one could assume that the exposure of a
  project to the country risk is proportional to
  its beta. In this case, one would add the
  country risk premium to the US market risk
  premium to get an overall risk premium. This
  would then be multiplied by the beta as before to
  obtain the project-specific risk premium.

17
Using the Country Risk Premium

• Finally, one could take the US market risk
  premium and multiply it by the ratio of the
  volatility of stock returns in the foreign
  country to the volatility of stock returns in the
  US.
• This is the country-risk adjusted market risk
  premium.
• As before, then, this market risk premium would
  be multiplied by the beta of the project to get
  the project-specific risk premium.

18
Adjusting for Country Risk

• Suppose the market risk premium in US markets is
  5.5
• The market risk premium in Germany is 8
• The yield on US 10 year treasuries is 5
• The yield on German government bonds is 6
• The world nominal risk-free rate (computed as the
  lowest risk-free rate that can be obtained
  globally, for borrowing in dollars or otherwise
  adjusted for exchange rate risk) is also assumed
  to be 5

19
Adjusting for Country Risk

• Project beta with respect to the German market is
  1.2
• Beta with respect to US market is 1.0
• Beta with respect to an international equity
  index is 1.1
• The volatility of returns (std devn) on a
  broad-based US market index is 25 per year.
• The volatility of returns on a broad-based German
  index is 35 per year.
• The volatility of returns on a broad-based world
  index is 30 (returns measured in dollars)

20
Adjusting for Country Risk

• Reqd. ROR US Riskfree rate bi(Market Risk
  Premium)
• If the investors in the project are investors who
  hold domestic (US) diversified portfolios, then
  we use US quantities. 
• If country risk is diversifiable or can otherwise
  be ignored,
• Reqd ROR 5 1 (5.5) 10.5, and country risk
  premium is set at zero.
• If the investors are internationally diversified,
  then
• Reqd ROR 5 1.1 (5.5) 11.05, and country
  risk premium is set at zero.
• If we take a weighted average of the two rates
  (in this example, we use 65-35 weights), we get
  0.65(10.5) (0. 53)(11.05) 10.6925

21
Adjusting for Country Risk

• If we believe that country risk is not
  diversifiable and/or is not otherwise captured in
  the beta computation or that it captures other
  kinds of risk that go beyond variability risk, we
  need to adjust for country risk.
• Add sovereign risk premium to the required rate
  of return(If we are worrying about country risk
  premiums, were probably discounting the
  existence of a single international asset pricing
  model, since it implies an integrated world
  strictly speaking, we could still hold that an
  international asset pricing model holds, but it
  is not a mean-variance model. We will ignore
  this here.)
• This gives us 5 (8 - 5) 1(5.5) 13.5

22
Adjusting for Country Risk

• If we assume that the country risk premium is
  shared by the project only to the extent that it
  moves with the market, then wed get
• Required ROR 5 1(5.5 3) 13.5 (in this
  case, the rate doesnt change) from 1.
• If we say that the country risk premium is shared
  by the project only to the extent that it moves
  with its local market
• Reqd ROR 5 1 (5.5) (1.2)(3) 14.1,
• Amplifying CAPM beta by volatility ratio
• Amplified beta 1x(35/30)
• Hence the required rate of return is 5
  1(35/30)(5.5) 11.42

23
The Cost of Debt Capital

• Suppose Alpha S.A., a French subsidiary of a US
  firm borrows 10m. for 1 year at an interest rate
  of 7. If the current rate is 0.87/, this
  would be a 8.7m. loan.
• If the end-of-year rate is expected to be
  0.85/, the dollar cost of the loan is only
  4.54, since (10.7)(0.85)/8.7 1.0454.
• In general, the dollar cost of a foreign currency
  loan with an interest rate of rL and a
  depreciation of the home currency of c per year
  is given by rL(1 c) c.
• If the loan is taken by a foreign subsidiary and
  the interest can be deducted for tax purposes,
  where the tax rate is ta, then the effective
  dollar rate is r rL(1c)(1-ta) c.

24
The Cost of Debt Capital

• In general, the effective dollar interest rate
  is, r, where
• c is the annual rate of appreciation of the local
  currency
• rL is the coupon rate of the loan
• ta is the affiliates marginal tax rate

• However, the solution to this general problem is
  the same as the solution to the single period
  problem.
• Finally, we put the cost of debt and the cost of
  equity together to get the WACC.

25
Problem 3, Chapter 14

• IBM is considering having its German affiliate
  issue a 10-year 100m. Bond denominated in euros
  and priced to yield 7.5. Alternatively, IBMs
  German unit can issue a dollar-denominated bond
  of the same size and maturity and carrying an
  interest rate of 6.7.
• If the euro is forecast to depreciate by 1.7
  annually, what is the expected dollar cost of the
  euro-denominated bond? How does this compare to
  the cost of the dollar bond?

26
Problem 3, Chapter 14

• The pre-tax cost of borrowing in euros at a
  interest rate of rL, if the euro is expected to
  depreciate against the dollar at an annual rate
  of c, is rL(1 c) c. There is a
  depreciation penalty applied to the interest
  (first term) and to the principal (second term).
• In this case, we get an expected cost of
  borrowing euros of 7.5(1-0.017)-1.7 or 5.67.
  This is below the 6.7 cost of borrowing s.
• If the German unit is taxed at ta, the ta, is r
  rL(1c)(1-ta) c. Thus, if ta 35, r
  7.5(1-0.017)(1-0.35) - 0.017, or 4.78.

27
Establishing a Worldwide Capital Structure

• As capital structure theory teaches us, the
  capital structure for the global firm as a whole
  should be determined, based on
• Volatility of worldwide earnings
• Bankruptcy cost
• Marginal Tax rate
• Nature of business and product/service.
• Since foreign operations may provide
  diversification and reduce earnings variability,
  an MNE may able to use more debt than a purely
  domestic corporation.

28
Foreign Subsidiary Capital Structure I

• The capital structure of the foreign subsidiary
  is relevant only if the parent company is willing
  to allow the subsidiary to default on its debt
  else there is only one capital structure.
• Even though, formally, there may be different
  capital structures for the parent and the
  subsidiary, in effect there is a single capital
  structure, that of the consolidated corporation.
• Alternatively, if the subsidiary issues debt,
  collateralized by its own assets or cash flows
  from local projects, without recourse to the
  parent, one can talk of a subsidiary capital
  structure.

29
Foreign Subsidiary Capital Structure II

• If the parent is borrowing the money and
  investing it in the subsidiary, then it does not
  really matter whether the investment in the
  subsidiary is called debt or equity.
• This is also equivalent to the case where the
  subsidiary borrows the money directly from a
  bank, instead of the parent borrowing it
  (assuming that the debt is guaranteed by the
  parent).
• In all these cases, the global debt-equity ratio
  will be the same that of the parent.

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Other Considerations

• Borrowing in the local currency can help reduce
  foreign exchange exposure. This may reduce the
  volatility or beta risk of the cashflows
  expressed in dollars. It should, in any case,
  reduce bankruptcy risk.
• Borrowing globally may be cheaper from a tax
  point of view local government subsidies may be
  available, too.
• Lending money to a subsidiary might mean easier
  repatriation of profits to the parent than
  structuring the investment in the subsidiary as
  equity.
• Raising funds locally can be useful if there is
  political risk. In case of expropriation, the
  parent can default on loans by local banks to the
  subsidiary.
• If funds can be raised in the foreign market with
  payment to be made with local cashflows alone and
  no recourse to the parent, this could reduce the
  likelihood of expropriation, as well.